Month: April 2014

Paul Krugman writes: “while banks are indeed more complicated creatures than the mechanical lenders of deposits we like to portray in Econ 101, this doesn’t mean either that they have unlimited ability to create money or that they are somehow outside the usual rules of economics”

I want to propose a very different view of banking than the one Krugman embraces. Banking is what makes the “usual rules of economics” conceivable. Remember that Adam Smith wrote the Wealth of Nations in 1770’s Scotland, which was one of the birthplaces of modern banking — and banking was having an extraordinary effect on the economy that Smith acknowledged. (Book II, Chapter 2, paras. 40-41 )

If one discards the neo-classical framework and conceives as the economy as an environment where the average person’s life is defined by liquidity constraints that preclude profitable investment, then one can understand banking as the crucial innovation that allows the average person to overcome liquidity constraints and, thus, that makes the neo-classical framework a meaningful model of economic behavior.

Of course, banks have never had “unlimited ability to create money” — even though the statement that banks “create money at the stroke of a pen” is a shorthand description that can be misread if taken out of context. Banking functions to alleviate liquidity constraints because of the institutional constraints on banks’ ability to create money — just as debt can alleviate liquidity constraints only if institutional constraints make it enforceable.

It is true that banks “create money at the stroke of a pen,” but it is also true that they are liable for the deposits that they create when doing so — just as they are liable for liquidity puts that make the issue of asset-backed commercial paper possible. It is the institutional structure in which banks operate which controls the money supply.

In my view, when there is an institutional infrastructure that makes it possible for banks to issue safe private sector assets abundantly, the economy performs well — because the new-classical framework becomes a not-unreasonable approximation of the economy. By contrast, when this institutional infrastructure starts to break down as it has in recent years, we begin to inhabit an economy where liquidity constraints are one of the most important forces in the average individual’s life and vast amounts of profitable investment never see the light of day.

A paper that expresses my view and its implications for shadow banking in detail is here. Some related posts are here, here, here and here.

I’ve finally organized the thoughts about banking that poured onto the pages of this blog in January. Unfortunately, the argument does not lend itself to convincing exposition in a blog post. So anybody who’s interested is going to have to trundle over to SSRN and download the paper, Shadow Banking: Why Modern Money Markets are Less Stable than 19th c. Money Markets but Shouldn’t Be Stabilized by a ‘Dealer of Last Resort’. I’ll warn you upfront, it’s tl;dr with a vengeance. On the other hand, I’m a pretty concise writer, so you’ll find I cover an awful lot of ground, if you give me an hour or two of your time.

Some highlights:

I start with Shadow Banking is an Unstable Funding System for Banks, Not Assets (so if you’re already familiar with the blogpost, you can skip that part).

I continue with my interpretation of why the industrial revolution took off in Britain: the banking system, of course — and it’s ability to create money. To make the point, I very briefly explain the nature of early modern financial markets, and how they gave birth to fiat money.

I then explain the components of the system that allowed 19th c. bankers to create risk-free private sector assets. Next I explain how these components fit in with a theoretic model of banking, and distinguish this model from Gorton and Ordonez model of “informationally insensitive” bank debt. (Don’t worry, no math.)

Then I argue that the 19th c. lender of last resort, as it was understood by Bagehot, did not only serve as a source of liquidity, when panics threatened a crisis of confidence in the (fundamentally sound) banking system, but also actively managed moral hazard by explicitly withdrawing support from institutions that were undermining the quality of the money supply.

At last I come back to modern shadow banking, explaining how the modern perversion of the “lender of last resort” into “too big to fail” has led to the growth of extraordinarily unstable forms of funding, including financial commercial paper and repo. Collateralized money markets in particular maximize the value of the central bank put, by draining liquidity when it’s most needed.

I explain why a “dealer of last resort” cannot support asset market prices in general, but can only protect asset markets from forced sales by the specific dealers who are granted access to the central bank.

Finally, I distinguish the tight connection that exists between traditional commercial banking and the real economy from the much more ambiguous relationship between traditional dealer banks and the real economy. After all, traditional dealer banks don’t hold assets on their balance sheets over the long term and are far more focused on their short-run ability to sell off an asset, than in the asset’s performance over the long run.

It is because of the important role that commercial banks play in the real economy that they have privileged access to the lender of last resort facilities of the central bank. Dealer banks don’t play the same role and don’t deserve similar support. As for shadow banking, repo markets, to the degree that they fund private sector assets at all, fund market-traded assets and don’t support unsecured lending to smaller businesses, whereas asset backed commercial paper markets are steadily shrinking now that avenues of regulatory arbitrage are being closed.

I had the good fortune to attend the INET 2014 conference this past weekend, to hear speak a variety of luminaries whose work I have been reading for years, and to meet bloggers with whom I have debated arcane points that none of my non-internet-based friends care about. I had a conversation there that I think sheds light on the causes of the Great Depression.

The gold standard is conventionally portrayed as synonymous with financial stability. … A central message of this book is that precisely the opposite was true. Far from being synonymous with stability, the gold standard itself was the principal threat to financial stability and economic prosperity between the wars.

More recently Eichengreen and Peter Temin conclude that a gold standard ideology played an important role in worsening the Depression. They quote in their conclusion an author who wrote in 1932:

What is astonishing is the extraordinary hold which what is called the gold mentality has obtained, especially among the high authorities of the world’s Central Banks. The gold standard has become a religion …

Certainly in retrospect it seems likely, that had Britain gone off gold in 1924 — before the accrual of seven years of credit imbalances built on a disequilibrium exchange rate — the world economy’s adjustment to that event would have been less traumatic than the events that took place after 1931. The question then is why there was such a strong commitment on the part of the world’s central bankers to supporting Britain in the maintenance of the gold standard.

I had a conversation at INET in which the following question was discussed: Why are the central bankers committed to coordinating with the ECB on protecting the Eurozone when there is a significant possibility that the politicians will fail to make the necessary adjustments, that the Eurozone will break apart, and that in retrospect their actions will appear ill-advised? The conclusion was this: from the point of view of the central bankers the immediate costs of failing to support the Eurozone are so high, that the central bankers have no choice but to have faith that the politicians will play the role they need to play.

If the same dynamic was at play historically, perhaps the golden fetters that chained central bankers in the 1920s and 30s were not ideological at all. But simply the fact that given a choice between causing an immediate crisis and leaving open the possibility, even if small, that the crisis can be avoided by political action, they could not bring themselves to take the pessimistic-realistic view. Maybe the central bankers in the 1920s and 30s felt that they had no choice but to place their faith in politicians, who were not worthy of that faith.

Prices very quickly reflect information, specifically the information that there are big informed buyers in the market.

That’s good! That’s good. It’s good for markets to be efficient. It’s good for prices to reflect information.

Let’s take this argument to the limit. Every order contains some small amount of information. Therefore every order should move the market (as they do in building block models of market microstructure)– and of course big orders should move the market even more than small orders. Matt Levine is claiming that this is the definition of efficiency.

But wait: What is the purpose of markets? Do we want them to be informationally efficient about the fundamental value of the assets, or do we want them to be informationally efficient about who needs/wants to buy and sell in the market? These are conflicting goals. When a hedge fund is forced to liquidate by margin calls, those sales contain no information about the fundamental value of the asset. Should prices reflect the market phenomena or should they reflect fundamental value? According to Matt Levine they should reflect the market not the fundamentals.

Matt Levine supports his view by referencing an academic paper that assumes on p. 3 that all orders contain some information about fundamental value — and thus assumes away the problem that some market information has nothing to do with fundamental value. With only a few exceptions the theory supporting the view that trade makes markets informationally efficient in the academic literature assumes (i) that informed traders trade on the basis of fundamental information about the value of the asset and (ii) that the informed traders have no opportunity to use their information strategically by delaying its deployment. Almost nobody models the issue of intermediaries trading on the basis of market information. And the whole literature by definition has nothing to say about efficiency in the sense of welfare (i.e. the Pareto criterion) because it assumes that liquidity traders are made strictly worse off by participating in markets.

It has long been recognized that liquidity is one of, if not, the most important service provided by secondary markets. Liquidity is the ability to buy or sell an asset in sizable amounts with little or no effect on the price.

Matt Levine’s version of informational efficiency presumes that there is no value to liquidity in markets. Every single order should move the market because there is some probability that it contains information.

I thought the reason that financial markets attract vast amounts of money from the uninformed was because they were carefully structured to provide liquidity and to ensure that the uninformed could get a fair price. Now it’s true that U.S. markets were never designed to be fair — and were undoubtedly described in extremely deprecating terms by London brokers and dealers for decades — at least prior to 1986. But there’s a big difference between arguing that markets don’t provide liquidity as well as they should, and arguing, as Matt Levine does, that the provision of liquidity should be sacrificed at the altar of some poorly defined concept of informational efficiency.

If Matt Levine is expressing the views of a large chunk of the financial world, then I guess we were all wrong about the purpose of financial markets: as far as the intermediaries are concerned the purpose of financial markets is to improve the welfare of the intermediaries because they’re the ones with access to information about the market. Good luck with that over the long run.

A true national market system would have the following property. There are clearly defined points of entry to the system: that is, when an order is placed on specific exchanges, ECNs or ATSs, they will count as part of the system. These orders are time-stamped by a perfectly synchronized process. In other words, it doesn’t matter where your point of entry is, the time-stamp on your order will put it in the correct order relative to every other part of the system.

Order matching engines are, then, required to take the time to check that time-priority is respected across the national market system as a whole.

This structure would eliminate many of the nefarious aspects of speedy trading, while at the same time allowing high-speed traders to provide liquidity within the constraints of a strictly time priority system. Speedy orders couldn’t step in front of existing orders, because time-priority would be violated. Cancellations couldn’t be executed until after the matching engine had swept the market to look for an order preceding the cancellation that required a fill. In short, speedy traders would be forced to take the actual risk of market making, by always being at risk of having their limit orders matched before they can be cancelled.

Overall, it seems to me that the error the SEC made was in creating a so-called “national market system” without a time-priority rule.

Note: this post was probably influenced by @rajivatbarnard ‘s tweets about this same topic today.

Update: Clark Gaebel explains very clearly that we don’t have anything remotely resembling a “national market system.” We have a plethora of independent trading venues and your trade execution is highly dependent on your routing decisions.